Are U.S. regulators worsening E.U. credit squeeze?

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“Our purpose is to lean against the winds of deflation or inflation, whichever way they are blowing.” -William McChesney Martin Jr., Chairman, Board of Governors of the Federal Reserve System

During his tenure as Chairman of the Fed from 1951 through 1970, William McChesney Martin Jr. saw the transition from America at war, with the government controlling much of the economy, to a peace time economy where wider financial ebbs and flows were possible. His experience in confronting both inflation and deflation during his term is instructive today.

The carefully managed, low-interest rate policy which the Fed maintained during WWII ended under Martin’s predecessors, Mariner Eccles and Thomas McCabe. These two Fed Chairmen defied President Harry Truman and raised interest rates to forestall inflation. Even when the Chinese Red Army attacked American military forces in Korea, the Fed under Chairman McCabe stood its ground and eventually won its independence from the Treasury in 1951.

But Martin recognized that the Fed ultimately could not prevent Congress from funding spending with debt and thereby fueling inflation, Alan Meltzer wrote in his classic “A History of the Federal Reserve.” That judgment has been proven correct in today’s market volatility, which is driven by the excessive accumulation of both public and private debt. But withdrawing liquidity from solvent borrowers risks a repeat of the Bear Stearns and Lehman Brothers failures.

Were he alive today, Martin would probably argue that the Fed should continue to encourage lending to solvent banks and thereby keep the financial system liquid and functional. I suspect that his successors, like Arthur Burns and Paul Volcker, would agree. But instead U.S. regulators are apparently encouraging American lenders to reduce credit risk exposure to E.U. banks and corporations, effectively exacerbating the liquidity crisis that has been hitting European markets in recent days.

The head of the credit risk book at one of the largest French banks told me yesterday that his institution has seen a one-third reduction in the volume of credit available from U.S. counterparties. He directly attributes this change to advice to U.S. banks from American regulators. The market veteran notes that long-term credit is unavailable for most E.U. banks, increasing pressure on short-term funding pressures in the dollar/euro market.

American officials apparently want to avoid another “AIG situation,” in the words of one well placed banker, thus reducing credit lines to E.U. banks is seen as a way to reduce systemic risk. But in fact just the opposite may be the case. The regulators may be fomenting a systemic risk event by going against the advice of Chairman Martin and most of his contemporaries.

I believe that the Fed needs to let the cost of funds rise to restore yield and risk taking to dollar assets, but at the same time make clear to the markets that the volume of credit available to solvent borrowers is unaffected or even increased. The contraction of money and credit on both side of the Atlantic is the key issue that should have the attention of policy makers. As Carl Weinberg of High Frequency Economics said on Bloomberg Radio this morning, nothing good comes from contracting credit and money markets. But low interest rates is driving deflation, in my view.

To the extent that regulators at the Fed, OCC and FDIC are encouraging U.S. banks to arbitrarily reduce credit lines to their E.U. counterparts, that behavior needs to end now. The chief threat to the global markets remains deflation as debt levels are reduced to practical levels. Next week, Fed Chairman Ben Bernanke and his colleagues at other agencies needs to make clear in a very public way that the U.S. central bank is not taking steps to make things in the money markets a lot worse than they need to be.

[...] of dollar funding to Eurobanks, and they have been pulling back. Chris Whalen also reported that US regulators are telling US banks to reduce credit exposures to Eurobanks. So much for the sort of central bank market-saving interventions that Bloomberg wants its [...]

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Christopher Whalen is the co-founder of Institutional Risk Analytics, the Torrance, CA, provider of bank and company ratings, custom analytics and consulting services for auditors, regulators and financial professionals. He edits The Institutional Risk Analyst, a weekly commentary on the personalities, institutions and markets which populate the global political economy.